Portfolio Manager Q&A - Mike Wachter

With yields back to levels not seen in over a decade, fixed income is experiencing a revival. Mike Wachter, Portfolio Manager and Head of Reinhart Fixed Income, shares his thoughts on the opportunity in bonds today.

Given the big move in rates last year, the inverted yield curve, and the volatility in the markets, where do you see opportunities in this environment?

Mike Wachter: For the last decade and a half, fixed income has been an incredibly challenged asset class. Rates had been kept low coming out of the Great Recession. There were points where the Fed started to raise interest rates, only to be forced to lower them quickly again – for example, during the pandemic. In general, without any yield in a portfolio, it is difficult to expect great returns from fixed income. That ended last year. We’re now sitting with yields in the 4.5% to 5% range in our portfolios. That yield that had previously been missing now provides investors with a base for solid returns. If interest rates do not change from here on out, you can expect a 4.5% to 5% return. That's a great starting level. Then consider the inverse relation between a bond’s price and rates. If interest rates were to move up from 4.5%, that yield would serve as a buffer against the negative price performance. If rates were to go down, you would get the 4.5% yield plus the additional price performance. All this considered, we think fixed income, as an entire asset class, is attractive right now.

When we started the year, there seemed to be a disconnect between what the Fed was planning and what the market was actually pricing in. Where do we stand today? And what are your expectations for rates moving forward?

MW: At the end of 2022 and into 2023, we started to see inflation moderating and signs of a slowdown in the economy. The market interpreted this as an indication that we may get rate cuts by the end of 2023, despite what the Fed has been saying about keeping rates higher for longer. Fast forward a month, we get a great nonfarm payroll unemployment report, retail sales are up 3%, and inflation data is stronger than expected. That flipped the market’s narrative on its head.

One thing I've learned in my 30-plus years as a fixed income investor is don't fight the Fed. That being said, I think that the Fed will do exactly what they are telling us they will do by continuing to raise rates. I don't expect them to stop until we get a fed funds rate north of 5%.

The big question is, will it have the effect that the Fed is looking for? Will it slow employment? Does it create more slack in the economy such that inflation will continue to come down? That’s what we’ll be watching for.

Let's get into the mechanics of bonds for a minute. Although yields in corporates and Treasuries are 4% to 5%, average coupons remain low in the 2% to 3% range. Can you comment on how investors will see their 4% to 5% return on these bonds?

MW: With market yields in the 4.5% to 5% range, no one would buy a bond with a 2% or 3% coupon unless you sell it to them at a discount. So, you ultimately achieve the higher market yield with the lower coupon level by accounting for the accretion of that discount towards maturity. For example, if I were to buy a five-year bond with a 3.5% coupon at a price of 95 cents on the dollar, over the course of that five years, I would add another 1% of yield on top of the coupon rate. It doesn’t work exactly like that, but conceptually, you buy a bond at a discount (95 cents) and are paid back at the full par value (1 dollar). The back-of-the-envelope math for this basic example would be: 3.5% coupon + 1% from the price going up each year = 4.5% yield.

Coming off a difficult year for both fixed income and equities, what is your message to investors on the role of fixed income in a portfolio?

MW: Even though both fixed income and equities experienced negative returns, fixed income returns, especially in intermediate high quality fixed income, were much better than equity returns. For example, high quality fixed income indexes were down single digits, while the S&P 500 was down over 18 percent. Looking forward, I think there is a real possibility of a recession in 2023. While this doesn’t always bode well for equities, we typically see lower rates in a recession, which could lead to decent fixed income performance. It’s also important to note that fixed income is starting the year with a yield in the four-plus percent range. So we are starting 2023 with a little bit of a head start and could potentially get even more return if rates are forced to go down, should we head into a recession.

The debt ceiling standoff has been in the news lately. What is your level of concern that this becomes a bigger risk? And are we making any portfolio changes because of this?

MW: If the United States were to default on its debt, it wouldn't be a calamitous event, and one that we really can’t plan for in a fixed income portfolio. I don't foresee this happening. Because of politics, we will continue to see headlines about it, but at the end of the day, I think the debt ceiling will be raised, and we will all go our merry way.

Wachter1 Mike Wachter, CFA is Portfolio Manager and Head of Reinhart Fixed Income
“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”). MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

Any performance data shown represents past performance. Past performance is no guarantee of future results.

Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.

This website is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.

The S&P 500® Index is an unmanaged index of large companies and is widely regarded as a standard for measuring large-cap and mid-cap U.S. stock-market performance. Results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index.

In addition to the ongoing market risk applicable to portfolio securities, bonds are subject to interest rate risk, credit risk and inflation risk. When interest rates rise, bond prices fall; generally, the longer a bond’s maturity, the more sensitive it is to this risk. Credit risk is the possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. Bonds may also be subject to call risk, which allows the issuer to retain the right to redeem the debt, fully or partially, before the scheduled maturity date. Proceeds from sales prior to maturity may be more or less than originally invested due to changes in market conditions or changes in the credit quality of the issuer.